After a challenging year for fixed income, investors could be forgiven for asking themselves, “what is the point of bonds anyway?”
The developed market government bonds and high-quality investment grade bonds that make up a typical core fixed income allocation have played a critical role in multi-asset portfolios for decades, providing income, diversification, low volatility and hedging characteristics.
The case for fixed income’s place in portfolios has been strengthened by the long-term structural decline in interest rates. Bonds also performed strongly after the global financial crisis of 2007-08, a period of low interest rates, low growth and copious bond buying by central banks as part of their quantitative easing programs. And in times of market stress, such as during the first Covid wave in 2020, bonds typically offer some protection and stability.
Investor sentiment should improve now it appears inflationary pressures have peaked
However, 2022 has flipped some of these previously held notions on their head, making questions about the role of bonds understandable. This year, bond markets have suffered substantial drawdowns, heightened volatility and more positive correlations to risk assets.
So, what changed? The biggest factor is the dramatic rise of inflation, leading to a determined effort from major central banks to raise rates to control it. Inflationary pressures were the result of the huge fiscal stimulus provided during the pandemic, coupled with disrupted global supply chains due to lockdowns. Russia’s invasion of Ukraine exacerbated these dynamics further, causing more supply chain disruptions and significant upward pressure on energy and commodity prices.
The dominant narrative of inflation and interest rates this year has also pushed the correlation between stocks and bonds to be mostly positive – hawkish central banks have caused stocks and bonds to fall in price, which has reduced the diversification benefits bonds provide against riskier parts of a portfolio.
Markets are still focused on inflation but we expect growth fears to take over as the dominant narrative before long. This should provide further support to defensive assets
This year was one of the worst on record for bond markets. But as the year has progressed, we have raised our exposure to core fixed income assets and are now modestly overweight. We believe the outlook is improving for two reasons.
First, investor sentiment should improve now it appears inflationary pressures have peaked. Commodity prices have fallen significantly from their highs and measures of supply chain deliveries have been normalising.
Separately, the prices paid components of the Institute for Supply Management surveys have come down, real average earnings have levelled off, real time rental indices are off the highs, as are used car sales, and job openings have levelled off. These all indicate US inflation should moderate, which we believe will support high quality fixed income assets such as government bonds.
Second, global growth continues to deteriorate, something we have been monitoring for some time. Markets are currently still focused on inflation, but we expect growth fears to take over as the dominant narrative before long. When it does, it should provide further support to defensive assets such as government bonds.
This leaves us decidedly more optimistic about the outlook for core fixed income than we have been at any time since taking over the management of the Fidelity Multi Asset Open fund range. We believe the fundamentals are turning – factors that have to date been headwinds are becoming tailwinds.
Overall, we continue to have a cautious stance. We are underweight equities given the ongoing challenging economic backdrop of this year. Our overweight position in alternatives also provides a less correlated source of returns and the potential for some protection from inflation that might yet take some time to come down to central banks’ 2% target.
Our focus remains on being flexible, looking to protect on the downside and embracing the breadth of opportunities our funds offer to our clients.